Sunday, January 14, 2007

Understanding Economics: Money

One of the key features of any modern economy is the use of money. Money is a unique good in that it is used as a store of value. Nonetheless, it follows the same rules of economics as any other good.

Primitive economies use barter. That is, they trade objects directly to improve their fortunes. However, barter has definite limitations, since it may not be possible to find someone willing to trade a given good in a given amount at a given time. Thus there is a need for a good that is used specifically as a store of value.

Many different goods have been used as money, but some are better than others. There are certain properties of money that are desirable. It should not decay over time. It should have high value per weight, so as to be easily transportable. It should be divisible. It should be of uniform quality. Perhaps most important, it should not be possible to counterfeit.

Putting all this together, we find that gold and other precious metals are the best type of money. For convenience, certificates redeemable for gold could be used.

When our country was founded, just such a monetary system was created. However, it has since been changed so that the government can print paper money that is not redeemable for anything. This is called fiat money.

What are the consequences of creating more money? When the supply of a good increases, we expect its price to drop. What does it mean for the price of money to drop?

Remember that money is only useful because it can be exchanged for something else. With a given amount of money in existence, prices are established for various goods. An equilibrium is reached with some frequency of exchanges of money and goods.

When more money is introduced into the system, it chases the same amount of goods. Stores start selling out of goods. People find that their money cannot as readily be exchanged for goods. The same is true for retailers. Thus the value of money decreases. Since the values of goods have not changed, more money is required to exchange for them. Thus prices increase.

When government creates more money out of nothing, this is called inflation of the money supply. The logic above shows that a necessary consequence of this inflation is an across-the-board increase in prices. This general increase in prices is what is most commonly known as inflation. This popular nomenclature conflates consequence with cause.

As mentioned above, one of the most important features of money is to not be easily counterfeited. When counterfeiters pass off phony money, they steal some of the value of everyone else's money. That is why counterfeiting is a crime that is punished harshly by the government.

As in many other areas of life, however, the government engages in the same practices that it forbids others to do. There is no distinction in principle between counterfeiting and inflation of the money supply. Both rob existing money of its value.

At best, inflation is simply another form of taxation. However, it is a particularly dangerous form of taxation, since most people don't realize that they are being taxed. When government inflates the money supply, the resulting general increase in prices is typically blamed on "greedy businessmen" and the like, rather than the true culprit, the government.

All too often, the demand for more and more money to finance war, entitlements, or other out-of-control government spending leads government to print more and more money. The amount printed increases exponentially as government attempts to wring the last remaining value out of people's money. This is known as hyperinflation. This explains the phenomenon of the amount of money increasing thousands or millions of times within short periods. Hyperinflation destroys people's savings and wrecks economies.

Thankfully, America has avoided hyperinflation. However, our government does inflate the money supply at a smaller level. While the inflation rate is almost always in the single digits, the effect of inflation compounds over time. Since the creation of the Federal Reserve in 1913, our money has lost 95% of its value. (See this inflation calculator.) To put it another way, government stole 95% of the value of our money.

Understanding the economics of money is necessary to prevent such disasters.

5 comments:

Anonymous
said...

Can someone remind me of what party the President who took us off the gold standard was from? Also, what would have happened had everyone with certifies (dollars) redeemed them for US gold all at one time? Finally, what is the difference between the cash-price cycle whereby wage earners consistently bargain for increased wages to help offset the costs of higher prices, which forces prices up and starts the cycle all over again? How does the government in that instance steal people’s money? I mean surly the only cause of inflation is a government policy of seigniorage right? And I’m confused as to how we cannot support the wars even if they cost a lot of money. If a Republican President says we have to invade a country, we can’t ask questions! We have to go! It’s what God wants!

Your comments, Allan, neglect a few important issues. One concerns your mischaracterization of the effects of low, long-term inflation. The other has to do with your support of some sort of Gold Standard. First, the effects of inflation do not occur as you contend. This is to say that, for example, in an economy experiencing across-the-board annual inflation of 2%, wages, prices, and everything else would go up by that value every 365 days. Rational economic agents will understand that rising prices are offset by rising wages and the net effect on the economy is essentially zero. In that regard, their purchasing power remains the same. Only those who save large amounts of cash outside of interest-bearing accounts would see a decrease in real value. Given that this money is not being used productively in the economy because it is not being invested, it is difficult to see the problem with a long-term decrease in value given that such a reduction would act as an incentive to put it to better use.

Your contention of the government "stealing" people's money via policies of inflation also neglects the role of money in the economy. There are instances when the money supply is non-neutral over the short-term and can produce real effects on other economic indicators such as GDP growth. Thus, government control of the money supply can be a necessary tool to prevent overall economic harm and a loss of output. Though this phenomenon is not completely understood, Ball and Romer argue in an article published in "The Review of Economic Studies," that there are conditions when wages and prices fail to adjust adequately. Though it does not always happen, this can lead to instances where money is decidedly non-neutral. Their article is available here: http://www.jstor.org/view/00346527/di990693/99p0163v/0. In such instances, control over the money supply is important. Your point about government printing of money is called into question then not only because it contends, falsely, that the government can create money out of nothing (that is to say with no adverse economic effects) but also because it must be balanced against instances were real economic harm can occur if the money supply is not adjusted.

Further consideration of this point finds that your support for a gold standard of sorts ignores the consensus in modern economics that such a standard was a large contributing factor to the Great Depression. On this point, see Eichengreen & Temin's article for the National Bureau of Economic Research. It is available here: http://www.nber.org/papers/W6060. Currencies redeemable for gold are less able than freely floating currencies to adjust to market conditions. Moreover, when foreign holders of a currency or gold certificate make a run on a country’s gold, that country faces little other choice by the deflate wages and prices. Important factors in labor market contract negotiations make such reductions in wages nearly impossible. For another skeptical view of a Gold Standard, see Milton Friedman’s "Capitalism and Democracy," specifically pages 40-43 in the 40th Anniversary Edition. Friedman’s discusses the impractical nature of any commodity standard and favors allowing the market to determine a currency’s value vis-à-vis other currencies.

These are a few points in response to your contentions concerning money in society. While there are some economists, namely members of the Austrian School, who hold similar views, they are not widely accepted among major economists.

Milton Freidman supported abolishing the Federal Reserve. One of his major contributions to economics is proving that inflation is always a monetary phenomenon. He advocated more pragmatic measures that had a better chance of being implemented (and were).

There is hardly a consensus among economists about the great depression. Some believe that government manipulation of the money caused the crash that began it. See Murray Rothbard's America's Great Depression.

A government policy that "only" steals your raise is hardly benign.

The views in this post are derived logically and any attempt to refute them should attack either my logic or the premises used.

What are you talking about Allan? Two articles were directly sourced in the comments. Moreover, the commenter acknowledged Rothbard as an economist of the Austrian school (one not taken seriously by most mainstream economists).

So what do you mean by logic? Where is that logic? You only made this positing a month after the formally anonymous made his posting because you know his arguments make sense, call into question your logic, and prove that your whole economic series is based on shaky ground.